Thus, under general practice, if an option writer (that is not a dealer) is a non-resident, and recognizes income with respect to the expiration, exercise, or sale of an option in the United States (which is not considered effectively connected income), the income should be characterized as foreign-source income and the writer would have no US tax liability. If the income were effectively connected income, the income would be subject to a graduated-rate, self-assessed tax on net income. However, this result is not free from doubt, and it is recommended that a taxpayer seek expert advice if a determination as to scoring needs to be made
B. Tax Treatment of holder
Premiums paid by an option holder are capitalizable, not deductible. The holder of an option generally recognizes gain or loss when it sells the option, terminates the options through offset or settlement, exercises a cash settlement option, or allows the option to lapse. Gain or loss on a sale of an option of upon cash settlement of an option generally equals the difference between the premium paid and the proceeds from the sale. If the option is exercised for property, the holder’s exercise of an option will generally not be a taxable event; instead, the holder will add the premium to the coast of the property acquired by exercising the option. Specifically, if an equity call option is exercised, its cost is added to the basis of the stock purchased. If a put option is exercised, its cost reduces the amount realized upon the sale of the underlying stock in determining gain or loss. If the holder is either a dealer or trader of if the option is part of a hedging transaction, the timing of gain and loss recognition will be different, as discussed above.
In general, if an equity call or put option is sold prior to exercise, any gain or loss recognized by the holder who is no a dealer or an electing trader should be capital gain or loss. The gain or loss will be short-term or long-term in nature, depending upon the holding period of the call or put option. If the call or put is allowed to expire without exercise, the expiration is treated as a sale or exchange of the call or put on the expiration date. The resulting loss is a capital loss, and is short-term or long-term, depending on the holding period of the call or put. If, however, the taxpayer is al dealer in either the underlying stock or the option themselves, gain or loss will be ordinary.
There are several tax rules that would suspend the holding period of an option, so as to limit an option holder from recognizing long-term capital gain income. The tax law provides for special treatment of straddles, which are defined as “offsetting positions in personal property”. Most particularly, a taxpayer may not take a loss on one of the positions in a straddle to the extent of unrealized gains in any other offsetting positions. In such case:
- the taxpayer must capitalize all expenses associated with carrying positions that are part of a straddle; and
- its holding period on any position that is part of a straddle does no begin to run until the position ceases to be part of the straddle.